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Perfecting a Security Interest in a Limited Liability Company Ownership Interest – Not a Simple Task

February 6, 2013

The Traditional Pledge Model

Many loans to small (and not-so-small) businesses include the requirement that the owners pledge to the lender their ownership interests in the prospective borrower. When the borrower is a corporation, the standard approach under the Uniform Commercial Code calls for the lender to perfect its security interest by obtaining physical possession of the certificates representing the stock, along with a “stock power” (separate endorsement by the owner that would allow the lender to transfer the stock to any purchaser in foreclosure). So long as the lender retains possession, it has a perfected, first-priority security interest in the pledged stock.

The World of Limited Liability Companies

Many organizations do business as limited liability companies. This business form (first adopted in Missouri in 1993) gives owners multiple benefits, including limited personal liability, pass-through taxation and flexibility in establishing rules for governance, capital contributions, allocations of losses and profits and distributions. Larger companies often start new ventures by forming one-member (100% parent owned) LLC’s to isolate other businesses from potential liability of the newly-commenced business. LLC’s have become the business vehicle of choice.

Perfecting a security interest in an LLC ownership interest is not simple. Various factors complicate the process, including:

The LLC interest could be deemed to be either a “security” or a “general intangible” for UCC purposes;

The LLC interest could be either “certificated” or “uncertificated”;

Changes to the operating agreement under which the LLC interest is issued could change the process for maintaining perfection of a security interest in the LLC interest.

Security or General Intangible?

Article 9 of the UCC separates personal property into “types.” Perfection of a security interest in different types of collateral requires different actions. Under most circumstances, an LLC interest is a “general intangible,” and the lender will perfect its security interest by filing an initial UCC financing statement in the state where the pledgor is “located,” which for an individual pledgor is the state of his/her principal residence and for a “registered organization” pledgor (corporation, LLC or limited partnership) is the state in which it was formed.

It is possible, however, for an LLC interest to be a “security” for UCC purposes. Under Article 8 - an Article of the UCC that lenders and their counsel seldom visit – an interest in a limited liability company (or a partnership, for that matter) is a security if “… its terms expressly provide that it is a security governed by this Article (Article 8) . . . .” Section 8-103. Therefore, if the certificate of organization or the operating agreement of an LLC so states, the lender is faced with the task of perfecting a security interest in a UCC-defined security.

Things get complicated at this point. If the security is certificated, a lender can perfect the security interest by taking possession with an effective endorsement (similar to taking possession of a stock certificate with a signed stock power). If the LLC interest is an uncertificated security, the lender will need to obtain “control” by obtaining an agreement from the LLC issuer to take instructions only from the lender regarding the LLC interest. In either case, the lender could simply file a UCC financing statement describing the security, although perfection by taking possession or control would have priority over perfection by filing.

In order to prevent the UCC interest from changing character (security into general intangible; certificated into uncertificated or vice versa) and thereby potentially voiding the method of perfection, the pledgor should be required to agree not to amend the LLC’s articles of organization or operating agreement relating to the UCC status of the LLC’s ownership interests without prior notice to allow the lender to perfect the security interest in the “changed” LLC interest.

A Practical Approach to Perfection

Under all circumstances, the lender should obtain a true copy of the certificate of organization and the operating agreement of the LLC whose membership interests are being pledged to confirm, among other things, whether the LLC interest is stated to be a security under the UCC. Then the lender (a) should perfect by obtaining possession of any certificate evidencing the LLC interest, with an endorsement allowing the certificate to be transferred freely upon foreclosure, or should obtain “control” by obtaining a control agreement from the issuer if the security is uncertificated and (b) should file a UCC financing statement in the state of location of the pledgor. Taking such actions will perfect a security interest in an LLC interest whether or not it is a security or at any time it changes its character (by an amendment to the articles of organization or operating agreement of the LLC) from a security to a general intangible or from a general intangible to a security.

How to Describe the Collateral

Another complication in the perfection process is that, unlike corporate stock, an equity ownership interest in a limited liability company by statute consists of two separate and distinct rights: (a) economic rights and (b) governance rights.

If in a security agreement and/or in the collateral section of a UCC financing statement the lender describes the collateral simply as a “membership interest,” “limited liability company interest,” “member’s interest” or the like, that description grants and perfects a security interest only in the member’s economic rights. Under the Missouri LLC Act, “member’s interest” means only “a member’s share of the profits and losses of a limited liability company and the right to receive distributions of limited liability company assets.” §347.010(12), R.S.Mo. The Delaware statute has an almost identical definition. §18-101(8), Delaware Limited Liability Company Act.

Governance rights – the power to vote on or consent to or approve LLC actions – are separate from LLC membership economic rights. Under Section §47.081-1(3) R.S.Mo., an LLC’s operating agreement governs “. . . the exercise or division of management or voting rights” among the LLC members. The Delaware LLC Act is similar. §18-302, entitled “Classes and Voting.”

Assuming that the lender’s intent is to obtain and perfect a security interest in all rights arising out of an LLC membership interest, both economic rights and management rights must be adequately described in the pledge or security agreement and adequately indicated in the UCC financing statement. One example of such a collateral description is:

All rights of debtor embodied in or arising out of debtor’s status as a member of _______________, LLC, a _______________ limited liability company (the “LLC”), consisting of: (a) all economic rights, including without limitation, all rights to share in the profits and losses of the LLC and all rights to receive distributions of the assets of the LLC; and (b) all governance rights, including without limitation, all rights to vote, consent to action and otherwise participate in the management of the LLC.

Conclusion

The UCC applies different perfection rules to general intangibles and securities. An LLC interest being pledged as collateral could fall into either category. The lender, with assistance of counsel, should first identify what the interest is and then decide whether the lender should require that the interest fall into a different UCC category. In most cases, an LLC interest is a general intangible. Once the lender has made that determination, issues of perfection and priority of the security interest can be addressed under the UCC Article 9 perfection rules.

The lender must also adequately describe the LLC interest being pledged in any pledge or security agreement and in any UCC financing statement to be filed in order to acquire and perfect a security interest in all of the LLC membership rights.

The biggest dangers for a lender are (a) to fail to determine the type of collateral presented in the form of an LLC interest and (b) to fail to describe properly the LLC interest in a pledge or security agreement or in a UCC financing statement. The result of such failures could be a defective attempt to acquire or perfect the security interest in a pledged LLC interest and could result in a lender only having a perfected security interest in the LLC economic rights or losing entirely its priority in the LLC interest over the debtor’s unsecured creditors.